When To Buy With RSI

Hey Everyone!

This is Enrique, and I am back with the latest edition of the STP Algo Trader User Blog.

One goal of this publication, every Wednesday, is to educate people on how to use our algorithmic trading system – Signal Trader Pro.

That isn't the ONLY goal, though, and even if you are not a subscriber, read on!

Our other goal is to educate folks on how to trade the markets using any good system or process. The trading disciplines that are best for Signal Trader Pro are also the disciplines that should govern any of your trading.

Today, we want to discuss how we use the different signals – ENTRY SIGNALS versus WATCHLIST.

Our system works by scoring stocks on a 15-point system. The points are based on several technical analyses and fundamental operating factors.

The higher the score, the more attractive the idea.

Historically, this has proven itself out as the BULLSEYE ideas – "14" and "15" – have nicely outperformed lower scores. The "12" and "13" categories also do pretty well, but the top scores do the best.

The 15th point is our ENTRY SIGNAL.

That is when a stock crosses below a relative strength index (“RSI”) of 30 and then back above that level.

Remember that RSI is a "velocity" measure of the stock price and indicates investor enthusiasm or pessimism. A high RSI (above 70) indicates high optimism and signals that the stock will likely take a breather.

A low RSI (below 30) is a sign of investor fear. Stocks that trade below this level and then back above it indicate a period of investor panic followed by some sentiment recovery.

This is a PERFECT time to buy high-score companies, as those are some of the best stocks in the market, and you are getting them with a great entry point.

In yesterday's STP Algo Trader, we wrote about favorite stock Talen Energy Corporation (TLN), and here (again) is the chart of the stock price and the RSI…

There are two green circles on the chart.

The most recent one was a classic RSI ENTRY SIGNAL generated in the selloff earlier this year.

TLN – a stock with a strong uptrend and a company with significant operating momentum – traded below an RSI of 30 and back above it.

This was a clear buy signal, and it paid off. BIG TIME.

Investors could have bought the stock at around $165 a share, and the stock traded at $300 earlier this week.

Looking back further in the chart, though, you will see another green circle.

This is when the stock traded down to an RSI of 37 during the July selloff that went into the August Japanese Yen carry trade stock market "freak out."

Here, the stock did not get below the 30 RSI level, but it was still a good buying opportunity.

Why did we buy the stock at that level, even if it did not go below a 30 RSI?

We recommended buying it because when you have the BEST stocks, you should be willing to buy them when they are deeply oversold – even if they don't breach this historical level.

There is no "magic" to the 30 level. Historically, it is a very good level, but for GREAT stocks, any level below 40 is interesting. Especially when they reach very overbought levels like TLN did at the time.

The Signal Trader Pro system, though, also generates WATCHLIST signals.

This is when a BULLSEYE scoring stock (“14” or “15”) trades below an RSI of 30 but has not yet traded back above this level.

Should a trader be buying these stocks?

Like most answers in trading and investing, the answer is it DEPENDS.

It is a complicated decision, and a lot depends on the stock's fundamental setup and investor base. This can be difficult for all but the most experienced investors to decide.

Our best advice is to buy them seldom.

As a general rule, if the stock's selloff appears to be a one-time event. A big "swoosh" in the context of a steady chart can be a good candidate to buy before the RSI recovery.

Be wary, though, when buying growth names – especially retailers – with high multiples. These are the most vulnerable to considerable sustained selloffs that could damage your portfolio before the stock recovers.